The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

(Photo credit: 401(K) 2013)

Investment books are a bit like golf instruction books. I’ve always felt that there is a bit of truth in all of them, plus a bunch of personal adaptations which might not work for anyone else but the author.

The other day something prompted me to go back and look at an old investment book I had by George Soros. It was a follow on to the “real time experiment” he developed in the book Alchemy of Finance. This one was humbly titled Soros on Soros, and is actually done in interview form, with Byron Wien as interviewer.

Soros developed a concept he calls reflexivity. The idea is that financial markets (and to a larger extent the economy as a whole) do not operate fully independent of the actions and biases of the participants. In fact, the participants in part shape the market outcome and the market outcome then alters the perceptions of the participants, working in a reflexive loop. Taken to an extreme it can create a sequence of boom and bust. One can see this sequence having played out in the markets of both 1999 and 2007.

I wonder today if we are not seeing that sequence beginning to now unwind in the bond market? psychology around deflation, recession and safety may have hit a crescendo in mid-summer 2012, right before the European Central Bank, the Federal Reserve, and more recently, the Bank of Japan began much more aggressive policy action. Since then, 10-year treasury yields are up close to 60 basis points.

If there is one thing you can take to the bank as an investor it is that all things are cyclical. That includes interest rates.

Equities……

The S&P 500 Index is coming up on breaking a near 13 year trading range. It’s interesting that retail has faded the whole thing, selling equities all the way through. The net coming out of the equity market has only shown the slightest inclination towards changing since the first of the year.

Equity markets when looked at in the near term are in a pretty definitive uptrend. The obvious question is what to make of this? It is clearly not the beginning. The market, as measured by the S&P 500 Index, has more than doubled since the spring of 2009. However, I don’t believe it’s the end either. Important markets tops come with a handful of key ingredients, including high valuations, a lot of optimism, and a treasury yield curve that is flat or even inverted. None of those things are evident now. Considering that quantitative easing is effectively the same as an interest rate cut below a zero bound, the yield curve is very steep even with 10-year yields just below 2%. That is usually good for risk assets. Though volatility can rear its ugly head just about any time, but the overall environment for the equity market appears good.

Generally, the thing people most commonly don’t like about equities right now are the width of margins. They are wide. The bearish assumption is that mean reversion will narrow them, eating into profits. Eventually this will be so. However, margins peaks and market peaks are not the same thing. Markets usually peak well after margins have begun to compress. Wage rates and large capital expenditures are the primary driver of this. It’s no big secret that labor markets are still very soft, so I don’t see a big inflation surge for the time being. That thought we’ll hold for a later date.

The last thing is that retail fund flows have a good track record of being ill-timed. The fact that interest rates are close to all-time lows and investors have piled into low yielding fixed income instruments the last several years, suggests to me that deflation is not a likely outcome. Juxtaposing this against the actions of central banks makes me suspicious that we are ultimately headed towards a period of above average inflation. Central banks have a funny way of getting what they want, eventually. They are working hard at reflating. I believe this may be good for stocks until inflation emerges, and Fed policy starts to normalize.